Mundell: Fed Easing May Spur Deflation in Europe

Federal Reserve debt purchases to stimulate the U.S. economy may send the euro rising against the dollar, sparking deflation in Europe, said Nobel Prize-winning economist Robert Mundell.

The European Central Bank would be unlikely to stem the euro’s gains, Mundell said in an interview in Beijing today. In an earlier speech, he said U.S. quantitative easing would hurt nations around the world.

Deflation would worsen European sovereign credit woes by making debts harder to pay off, said Mundell, who won a Nobel Prize in economics in 1999 and is credited as the intellectual father of the euro. His warning highlights potential unintended consequences of U.S. policy after Brazil said last month that the Fed risks inflating asset bubbles elsewhere.

European governments are imposing austerity measures after a near-default by Greece, a European Union rescue package, and debt rating downgrades for nations such as Ireland, Portugal and Spain. In the U.S., the Fed may announce a second round of quantitative easing after a two-day meeting ends today in Washington.

The European Central Bank’s mandate to control inflation would likely hamper it from stemming the euro’s rise, while the currency’s gains would “likely lead to deflation,” Mundell said. Falling prices would increase “the real value of indebtedness.”

‘Terrorizing’ the World

U.S. policy makers will restart a program of securities purchases to spur growth, reduce unemployment and increase inflation, said 53 of 56 economists surveyed by Bloomberg News last week. Twenty-nine estimated the Fed will pledge to buy $500 billion or more.

In an earlier speech at a forum run by Bank of America- Merrill Lynch, Mundell, 78, said the Fed’s quantitative easing was “terrorizing” the world economy. In the interview, he drew parallels between a quantitative easing-induced dollar devaluation and the “inflation tax” of the 1970s, where depreciation caused by rising U.S. prices reduced the value of dollar holdings of governments and investors around the world.

“Dollars were depreciating in value, dollars were the major reserve, this was a tax on dollars held outside” the U.S., Mundell said.

Asset Bubbles

Brazilian Central Bank President Henrique Meirelles said Oct. 26 that an “expansionary monetary policy in some countries, particularly in the U.S.,” is creating challenges for economies such as his by leading to currency appreciation and potential asset bubbles.

Leaders of the Group of 20 nations are seeking to reduce global imbalances in trade and saving and spending to limit the likelihood of another financial crisis.

Mundell said that a proposal by U.S. Treasury Secretary Timothy F. Geithner to cap current-account imbalances at 4 percent of gross domestic product would be attractive to China, especially as an alternative to legislation that would give President Barack Obama more power to penalize countries deemed to have undervalued currencies.

“It’s something China could live with,” said Mundell, who’s a professor at Columbia University.

He previously called for the European currency to be fixed against the dollar and described China’s crisis policy of pegging the yuan to the greenback as a “great source of stability” for China and the world. It’s a bad idea for the U.S. to insist China revalue, he said today.

Joseph Yam, the former head of the Hong Kong Monetary Authority, said today that emerging economies may use measures such as temporary capital controls and currency appreciation to cope with capital inflows. He spoke at the same forum as Mundell.

In a report on the Chinese economy today, the World Bank said that the abundant liquidity from loose monetary policy in developed nations is likely to flow into fast-growing Asia.